How important to investing is trading?

I didn't provide any specific pointer for my contention that George Soros, in his great book "The Alchemy of Finance", says his trading (in the glorious year he chronicles throughout part III as "The Real Time Experiment" -- 1985-86) was poor. Fortunately, thanks to Google Books' search ability, it's really very easy to check: just go to the book and search for trading, and you'll find as the top two hits of the search:

• p. 308: "The record shows that my trading was far from flawless even in Phase 1. I was too late in buying bonds and too early in selling them" (&c).
• p. 207: "In short, my trading was poor".

and more hits such as

• p. 160: "On balance, my trading has been poor"

not to mention other choice (not fully germane, but irresistible to quote;-) tidbits such as (p. 278) "At present, the stock market is dominated by program trading and portfolio insurance schemes. These schemes are fundamentally unsound. They virtually assure a loss for exchange for peace of mind in a declining market."

Isn't George Soros, among the legendary investors, primarily a trader (as opposed to, say, Warren Buffett, notoriously more of a buy-and-hold type)? And, if so, how can he make money while repeatedly bemoaning his own trading? Read the book for the detailed answers, but, in short: overall, through the year, he was directionally right. E.g., wrt the first search hit above: he did buy bonds cheap (though definitely not as cheap as he might have bought them in hindsight had he timed the bottom in that market perfectly) and sold them dear (though not as dear as he might have sold them in hindsight had he timed the top in that market perfectly).

Nobody can time the market perfectly in the sense of accurately calling the bottoms and tops -- but it doesn't matter as much as our hindsight-based perfectionism screams in our inner ear: as long as we buy cheap and sell dear, we're still making good money. Making good money, just a bit less than you"might" have on the same trade in hindsight, had you timed it perfectly, is not losing money, and framing it as a loss is deleterious to our best judgment since it triggers strong "loss aversion" impulses in our brain.

Even in a dynamic, strongly trading-based investment style like Soros', what matters is being mostly right, most of the time -- that's even more so, of course, in a diametrically opposed (call it Buffett-like) investment style, where the trading part (the buying and the selling) is merely instrumental to the real money making, which is obtained by holding (or, being short of) the right securities at roughly the right time.

More on "The ABC of Stock Speculation" - part 2: "get rich quick" schemes vs patience and prudence

disadvantage of the small operator in following this policy is that he seldom provides sufficient capital for his requirementsContinuing the idea I started here, I'll keep irregularly doing some posts based on quotes from Nelson's 1902 book -- all the quotes in this and other posts of this ilk are from Google Books' scans, except for typo corrections I'm making along the way.

It is an old saying in Wall Street that the man who begins to speculate in stocks with the intention of making a fortune, usually goes broke, whereas the man who trades with a view of getting good interest on his money, sometimes gets rich.

This is only another way of saying that money is made by conservative trading rather than by the effort to get large profits by taking large risks.

Nelson's core idea for this "conservative trading"

starts with the assumption that the operator knows approximately the value of the stock in which he proposes to deal. It assumes that he has considered the tendency of the general market; that he realizes whether the stock in which he proposes to deal is relatively up or down, and that he feels sure of its value for at least months to come.
Suppose this to exist: The operator lays out his plan of campaign on the theory that he will buy his first lot of stock at what he considers the right price and the right time, and will then buy an equal amount every 1 per cent. down as far as the decline may go.

This systematic "averaging down" procedure, of course, when compared to simply buying your whole position (whatever total amount you're comfortable investing in the stock) when the stock reaches "the right price and the right time", saddles you with far more in commissions (and that was even truer in Nelson's time, when commissions were more substantial -- nowadays, depending on your broker &c, you may get a number of commission-free operations, or pay a very small amount even for non-commission-free ones).

More importantly, it makes the overall size of your position highly dependent on Mr Market's whims -- after all, as Nelson says, "Any operator proposing to follow a stock down, buying on a scale, should make his preparations for a possible fall of from 20 to 30 points. Assuming that he does not begin to buy until his stock is 5 points down from the top, there is still a possibility of having to buy 20 lots before the turn will come" (!). So, if you're prepared (say) to invest a total of $10,000 in stock X, you must do it in $500 increments... and may end up owning only $500 or $1000 of it if the decline on which you start buying lasts but a short time!

Whether these substantial strategic disadvantages are compensated by reducing your overall cost basis by up to 10% downwards (buying 20 lots "on a scale" at price points decreasing by 1% each time) may depend on individual tastes... to me, though, this sounds like a procedure for trading, not one for investing. I'm definitely not a great trader -- and I find it heartening to read in George Soros' fascinating book "The Alchemy of Finance" (highly recommended, BTW) that he disparages his own trading (short-term market-timing, &c) skills in even less-uncertain terms (!). Maybe (said he self-soothingly) there's a negative correlation there...?-)

Nevertheless, net of specific procedures, I think that the core messages -- "money is made by conservative trading rather than by the effort to get large profits by taking large risks", and "don't over-trade!" -- or, as Nelson puts it, that the

disadvantage of the small operator in following this policy is that he seldom provides sufficient capital for his requirements

(i.e., he over-trades, over-margins himself, and so forth) -- remain, after more than a century, immortal principles to live by.

The "stop-loss" controversy: Fisher, Nelson, Montier and me

One of Ken Fisher's entries in "debunkery" which I do agree with is the one summarized pithily on the book jacket as "stop-losses should be called stop-gains" -- though in this case I'm not sure whether I agree with his main reason for saying so (i.e., that "stock prices aren't serially correlated" -- Stein and DeMuth have shown that 10-years running average of price measures for the real [inflation corrected] S&P500 _are_ predictive enough of the market's returns over the next 20 years that a long-term investor using those prices is much better off than one doing "buy and hold" instead, for example; yet this example of extreme long-termism is as contrary to the popular myth of the perfectly efficient, aka "not serially correlated" market prices, as any other bit of chartism, from the venerable Dow Theory, to the "momentum" craze, &c... I'm as intuitively averse to the chartism/technically mumbo-jumbo as clearly Fisher is, but definitely not because of dogmatic adherence to "efficient markets", which I find just as unconvincing... so, I'm studying up and refreshing on all sorts of such theories, of both ilks, to try and fight my own confirmation bias on the matter).

Rather, I think S.A. Nelson has it right in his "ABC of Stock Speculation" masterpiece. There are two main ways of speculating in stocks (in 1902, when Nelson's book was written, all trading and investing in the stock market was also called "speculation"): the only way that's ever made really great fortunes, based on deep study (and continuous re-checking) of firms' actual values -- and short-term, pure trading/gambling approaches where the underlying firm is hardly considered, and everything hinges on "what the market will bear"... the market price (which of course a lot of theorists, from Dow himself all the way to dogmatic "efficient market" theorists, will and do at times claim embodies all there possibly is to know about a firm). In the second case, stop losses are not a bad idea (though Nelson justifies them, essentially, by a model of the grand-scale stock manipulation that the short-term trader is trying to coattail-ride on).

If I get into a stock because I'm gambling that it will rise a lot soon, and it goes down substantially instead, then the stop-loss may indeed reduce (though never of course eliminate) my losses on the losing gamble. But if I get into a stock because I'm convinced after thorough study that it's really worth 50 and it's now priced at 35, then, if the stock's market price further decreases to 25 (and, re-checking carefully all my reasoning as to why it's really worth 50, I'm confirmed in that opinion), then the stock is now even more of a bargain, and quite possibly some funds that were previously otherwise employed should be freed to purchase more of the stock in question. While perhaps not "efficient", the market will eventually sync up with a firm's real value -- the patient value investor counts on that! In this approach to investing, stop loss orders make absolutely no sense!

The old saw "ride your winners, cut your losers" only makes sense in a pure trading, not investing, perspective, as "winners" are intrinsically defined here as "stock which increased in price after I purchased them" and vice versa for "losers". That's what makes it particularly sad to see the very worst piece of advice in Montier's "Little Book of Behavioral Investing" -- that "stop losses may be a useful form of pre-commitment that help alleviate the disposition effect in markets that witness momentum". Only for a pure trader, somebody who needs to accept the current market price as the total determinant of the underlying firm's overall worth -- which is really very contradictory with most else that Montier is saying in that otherwise decent book...!